Why the Fed is watching a rise in an interest-rate benchmark pegged to trillions

It isn’t ringing the same alarm bells it rang a decade ago, but a continued rise in a closely watched short-term interest rate tied to trillions of dollars worth of loans and financial products world-wide is on the Federal Reserve’s radar.

Analysts at Bank of America Merrill Lynch noted Tuesday that the Fed is monitoring the continued rise in the London interbank offered rate, or Libor, for dollars. In particular, the Fed’s most recent dealer survey specifically asked about reasons behind the widening of the spread between the three-month Libor rate and the overnight index swap rate, or OIS. The Libor-OIS spread, a gauge of funding costs for banks, has widened sharply (see chart below).

The Libor-OIS spread is now the widest its been since 2012, when worries about the eurozone debt crisis were at their peak. A much sharper rise in Libor and a blowout of the Libor-OIS spread in 2008 underlined stresses facing the financial system in the darkest days of the financial crisis. A virtual freeze in interbank lending amid solvency worries fueled fears of a domino-like collapse of the banking sector.

Needless to say, current conditions are nowhere near the same order of severity. In fact, stock-market investors aren’t alarmed. That’s at least by virtue of gains in popular gauges of the banking sector, with the KBW Bank Index
BKX, -0.14%
up 7.8% year-to-date, outperforming the S&P 500’s
SPX, +0.38%
4% rise through the first three months of the year.

In fact, the recent advance appears to have little to do with stresses in the banking sector. Instead, top reasons include a jump in the issuance of short-term Treasury bills following the suspension of the debt ceiling last month and the repatriation of profits held abroad by U.S. corporations following the passage of tax-cut legislation last year.

The jump in T-bill issuance—The Treasury has issued a net $283 billion over the past five weeks, double the net issuance seen in 2017—has caused bills to cheapen significantly versus OIS and led, in turn, to a cheapening of other money market products, forcing banks to pay more for funding. Yields rise as debt prices fall.

Repatriation is the second most important factor, the analysts said, on expectations corporations will redeem short-dated money-market funds, pushing up yields. The Fed’s continued unwind of its balance sheet will also serve to drain excess reserves and tighten funding, they noted.

While those pressures are likely to further widen the spread in the near term, the presence of the Fed’s bilateral liquidity swap lines with the European Central Bank, Bank of Japan and other major central banks should keep the spread from expanding beyond 50 basis points, they said. And after the first quarter, funding pressures should subside, albeit slowly, as the Treasury temporarily cuts bill supply as tax receipts roll in. And they don’t expect any rapid retracement of the recent widening, with Treasury likely to step issuance up again after the second quarter while repatriation and the Fed balance-sheet unwind remain factors.

For the Fed, it would be a much greater concern if the Libor rise was reflecting heightened concerns about bank credit instead of structural supply-and-demand factors at the front end of the rates curve, the analysts wrote.

And policy makers will become concerned with financial conditions “only if it spills over into broader corporate borrowing/investment activity” or begins to weigh on consumer or business confidence.

“Overall, we do not think the rise in Libor is yet sufficient to derail the Fed from their gradual tightening cycle, but they will likely be more attuned to financial conditions given the recent rise,” they wrote.

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